In practically all shareholder disputes concerning the sale of a company, the rules of the game determine who wins. So, as you plan the sale of a company it is important to pick the right rule book. For example, if the business judgment rule applies, the sellers in a contested transaction will likely prevail because the standard to pass this test is low and the parties contesting the sale have the burden to prove that directors of the company breached a duty of loyalty or care related to the sale. On the other hand, if the entire fairness standard applies to the transaction then the sellers are doomed because it is more difficult to pass this standard and the sellers will have the burden to show that the transaction was entirely fair.
So how do a company and a control group of shareholders pick the right rule book when the control group of shareholders is seeking a premium for its shares when selling the business to an unaffiliated third party? In a recent case the Delaware chancery court provided a roadmap for sellers in this situation so that sellers can fix the game in their favor by ensuring that they will receive business judgment rule treatment when the court reviews the transaction. Well, at least until the Delaware Supreme Court decides on this issue.
In this case, a group of four shareholders owned over 70% of the outstanding common stock of the seller. The seller appointed a special committee of disinterested directors to negotiate the terms and conditions of any proposed sale of the business. Ultimately, the seller entered into a merger agreement with a private equity firm where all shareholders would receive $2.87 per share. The control group of shareholders entered into three additional agreements with the buyer: a voting agreement where they agreed to vote in favor of the merger, an employment agreement and an exchange agreement where they would exchange about 17% of seller’s common stock that they held for a nearly 15% equity interest in the buyer. The merger agreement did not require a majority of the disinterested shareholders to approve the merger although this in fact actually happened.
The Delaware Chancery Court stated that the business judgment rule will apply in a sale of a business to a non-affiliated buyer where a controlling shareholders will receive a premium for their shares if the transaction is recommended by a disinterested and independent special committee of directors and a majority of the minority stockholders approve the transaction in a non-waivable vote. As the merger agreement did not require a majority of the minority shareholder vote, the dreaded entire fairness standard applied and the defendants’ attempt to dismiss the case at the beginning of the litigation failed. You can easily avoid this result in a similar transaction if you pay attention to the process that will be implemented to negotiate and approve the transaction.
This important step is the way to pick the right rule book.